The Supply of Labour

This may appear to be a straightforward topic. What is the supply of labour? But before we dive in, we need to appreciate that there are many different 'types' of labour supply.

First, we will look at the individual's supply of labour. How many hours of work per week is a worker prepared to offer at different wage rates?

Secondly, we will need to establish what the firm's supply of labour curve looks like. The shape of this curve will depend upon whether the firm is in a perfectly competitive labour market or an imperfectly competitive labour market, whether the labour market is competitive or otherwise is not necessarily linked to whether the product market is competitive or not, but imperfect product markets (like oligopoly or monopoly) tend to breed less competitive labour markets.

Thirdly, we need to think about the labour supply curve for the whole industry. In particular, we will need to think about the elasticity of this curve.

Finally, there is the supply of labour to the whole economy. This is quite a big sub-topic that is covered in a separate Learn-it called 'The UK labour market'.

What will the individual worker's supply curve look like? At first glance, this may seem fairly obvious. The higher the wage, the more hours a person would want to work so that he can make more money. But it is more complicated than that. As the wage rate rises, there are two things going on.

On the one hand (the obvious part above) the higher wage will mean that the worker will offer himself for more hours. The price of 'leisure' has become relatively more expensive (because each hour taken off is costing the worker a higher hourly wage) so the worker will substitute 'leisure' hours for 'work' hours (so he works more hours and has less time off). This is called the substitution effect of a wage rise and is always positive (i.e. a rise in the real wage causes a rise in the hours worked). You may remember that this term is used when discussing income elasticity, normal goods and inferior goods.

On the other hand, the higher wage will mean that the individual's real income will have risen, ceteris paribus. Although some people never seem to have enough money, many will get to the stage, at higher wage rates, where they are earning quite a lot of money and would like to spend more time at home with their children, or just go on more holidays. Their demand for most goods rises as their real income rises, including 'leisure'. What is the point of earning lots of money if you have no spare time to enjoy it? So, there is an income effect of a wage rise as well. As the real wage rises, the income effect causes the hours worked to fall (i.e. the income effect is always negative).

Look at the diagram above. This is what we call a backward bending supply curve (for obvious reasons!). Notice that the y-axis is labelled 'real wage'. It is important that we look at hours worked relative to the real wage. The whole point of the income effect is that the worker feels richer and so decides to 'buy' more leisure time and work fewer hours. If the wage rate rises, but at the same time the average price level rises too, then the worker will not feel any richer at all.

The section of the curve up to point A is upward sloping. This means that as the real wage rises, the individual works more hours each week. In this portion of the curve, the substitution effect is stronger than the income effect. This is to be expected. At lower real wage rates workers do not tend to feel so rich that they feel they can afford a day off each week! If anything, at lower wage rates, any rise in the real wage rate will encourage a individual to work more hours to earn even more money.

Above point A, the curve bends backwards. As the real wage rate rises, the individual decides to work fewer hours. After point A, the income effect begins to outweigh the substitution effect. In a sense, a target income has been reached, so if the real wage rises the individual can still earn his target income by working fewer hours. In fact, if you look at the diagram, at real wage W2, the individual works fewer hours than at real wage W1, but his overall weekly income is still higher (OW2BH2 > OW1AH1).

As we said earlier, the shape of the firm's supply curve will depend on whether the labour market is perfectly or imperfectly competitive. Let's start with firms in perfectly competitive labour markets.

Perfectly competitive labour markets and their supply of labour curves

As with perfectly competitive product markets, perfectly competitive labour markets have numerous buyers and sellers. Remember that in a perfectly competitive product market, the firm could sell as much as it wanted at the given market price. It could not affect the market price through its actions, but at least there was no shortage of buyers at the given market price.

The situation is similar in a perfectly competitive labour market. The going wage is determined in the market and no one firm can affect this given wage through its actions. But, each firm can employ as many workers as it wants at this given wage. There are so many workers that none of them will be successful in trying to obtain a higher wage. The individual firm's supply of labour curve, therefore, will be horizontal, or perfectly elastic.

The industry will have a normal looking upward sloping supply curve for labour. This could be explained by stating the common sense proposition that the higher the wage, the higher the number of workers who will offer their labour services (the substitution effect is stronger than the income effect for the whole economy). This argument is talking about the supply of labour to the economy as a whole, though. It does make sense, though, for the supply of labour to rise in a given industry as the real wage rises, ceteris paribus. The higher relative wage should attract workers from other, similar, industries increasing the total supply of workers. It may attract workers away from voluntary unemployment as well.

The supply curves for the individual firm and the industry are drawn below.

Imperfectly competitive labour markets and their supply of labour curves

If the labour market in question is imperfect, then the perfect assumption of infinite numbers of employers and workers no longer exists. Economists often like to look at the other extreme as a benchmark.

Imagine that there was only one employer. This means that there is only one buyer of labour. Monopoly is the situation where there is only one seller in the product market, and is known as monopoly. If there is only one buyer then the situation is known as monopsony. Usually, if there is only one buyer of labour in the industry, then that firm is the only seller in the industry, so the two situations often coincide. The government has a certain amount of monopsony power. It employs the majority of teachers and nurses in the UK, for example.

In perfectly competitive labour markets, the industry supply of labour curve is upward sloping, but the marginal factor cost (MFC) for each firm remains constant. The extra cost of employing each worker is always the same (the firm's supply curve is perfectly elastic).

In monopsony, the industry supply of labour curve is now the supply curve for the firm in question. But what will the firm's MFC curve look like?

Although a monopsonist has a lot of power in the labour market, it does have to raise the real wage rate if it wants to employ more workers. If a monopsonist employs 100 workers at a wage rate of £5 per hour, then his wage bill is £500 per hour. If he then has to raise the wage to, say, £5.05 per hour to attract another worker, what do you think the extra cost of employing that worker will be? £5.05? Wrong I'm afraid. The extra cost of employing the 101st worker is the £5.05 per hour that you pay that worker plus the extra 5p per hour that you must pay the other 100 workers (which is £5). So the total extra cost (the MFC) is £10.05. This analysis is true at all real wage rates. Hence, the MFC curve will always be above the firm's supply curve, as can be seen from the diagram below.

Notice that when the real wage rate is £5.05 (which is read off the firm's supply curve), the MFC is £10.05 (read off the MFC curve). Also notice that I've labelled the supply curve (SL) as AFC. This is the average factor cost. The wage rate is also the cost to the firm, on average, of employing L1 workers. One final point to note, the AFC and MFC curves above are the mirror image of the AR and MR curves of the monopolist. This is perhaps a good way of remembering the curves. Most monopolists are monopsonists, and the curves are reflections of each other.

The main determinant is the level of skill required in the given industry. In low skill industries, a rise in the real wage rate will probably cause a proportionately larger rise in the supply of labour into that industry, ceteris paribus. Not only is there a bigger pool of unskilled workers generally (many of which may be unemployed), but there will be many other industries in the economy that only require low skill levels, from which workers can move to the industry whose relative wage has risen. Wage rates in low skill industries are often fairly similar, given that the productivity levels in these industries are fairly similar (the workers MRPs are similar). So, the rise in the wage rate for one of these industries does not have to be very large to attract a large number of workers from the other industries.

As with the elasticity of supply in the product market, time is a big factor for the elasticity of the labour supply curve. In July 2000, the government announced huge increases in spending on the NHS. One of their goals was to increase the numbers of nurses and doctors significantly. Money would be required for training, but their wage rate would have to rise to attract the required workers. In the short run, though, the supply of nurses and doctors will not be very responsive to a rise in the real wage rate. Although many workers might be keen to enter the industry, it takes a number of years to train for the job fully. The supply of labour curve is relatively inelastic (a steep curve) in the short run. As time goes by, though, many of the enthusiastic workers who responded to the rise in the real wage rate will be fully trained. In the longer run, the supply of labour is relatively elastic (a flattish curve).